Nevada Partners Fund, L.L.C. v. United States

Case: 10-60559 Document: 00512284556 Page: 1 Date Filed: 06/24/2013
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
June 24, 2013
No. 10-60559 Lyle W. Cayce
Clerk
NEVADA PARTNERS FUND, L.L.C., by and through Sapphire II,
Incorporated. Tax Matters Partner
Plaintiff - Appellant Cross-Appellee
v.
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service
Defendant - Appellee Cross-Appellant
--------------------------------------------------------------------------------------------------
CARSON PARTNERS FUND, L.L.C., by and through Sapphire II,
Incorporated, Tax Matters Partner
Plaintiff - Appellant Cross-Appellee
v.
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service
Defendant - Appellee Cross-Appellant
--------------------------------------------------------------------------------------------------
RENO PARTNERS FUND, L.L.C., by and through Carson Partners Fund,
L.L.C., Tax Matters Partner,
Plaintiff - Appellant Cross-Appellee
v.
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No. 10-60559
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service,
Defendant - Appellee Cross-Appellant
--------------------------------------------------------------------------------------------------
CARSON PARTNERS FUND, L.L.C., by and through Nevada Partners Fund,
L.L.C., Tax Matters Partner
Plaintiff - Appellant Cross-Appellee
v.
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service
Defendant - Appellee Cross-Appellant
--------------------------------------------------------------------------------------------------
RENO PARTNERS FUND, L.L.C., by and through Delta Currency
Management Company, Tax Matters Partner
Plaintiff - Appellant Cross-Appellee
v.
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service
Defendant - Appellee Cross-Appellant
--------------------------------------------------------------------------------------------------
CARSON PARTNERS FUND, L.L.C., by and through Bricolage Capital
Management Company, Tax Matters Partner
Plaintiff - Appellant Cross-Appellee
v.
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service
Defendant - Appellee Cross-Appellant
--------------------------------------------------------------------------------------------------
2
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NEVADA PARTNERS FUND, L.L.C., by and through Bricolage Capital
Management Company, Tax Matter Partner
Plaintiff - Appellant Cross-Appellee
v.
UNITED STATES OF AMERICA, by and through its agent, the Internal
Revenue Service
Defendant - Appellee Cross-Appellant
Appeals from the United States District Court
for the Southern District of Mississippi
Before KING, BENAVIDES, and DENNIS, Circuit Judges.
JAMES L. DENNIS, Circuit Judge:
This appeal arises from eleven notices of final partnership administrative
adjustment (FPAAs) issued by the IRS with respect to three Limited Liability
Companies (LLCs) treated as partnerships for tax purposes:1 Nevada Partners
Fund, LLC (“Nevada”), Carson Partners Fund (“Carson”), and Reno Partners
Fund, LLC (“Reno”) (collectively, the “plaintiffs” or “partnerships”). See 26
U.S.C. §§ 6223, 6226(a). The FPAAs eliminated approximately $18 million of
claimed tax losses and determined that penalties were applicable. According to
the IRS, the partnerships’ transactions provide one partner, James Kelley
1
The Internal Revenue Code does not address or define limited liability companies,
which are business entities established under state law. See 26 C.F.R. § 301.7701-1(a)(1)
(“Whether an organization is an entity separate from its owners for federal tax purposes is a
matter of federal tax law and does not depend on whether the organization is recognized as
an entity under local law.”). The Treasury Regulations allow an LLC to “elect its classification
for federal tax purposes”; the regulations treat a multi-owner LLC as either an association or
partnership, and treat a single-owner LLC as an association or “to be disregarded as an entity
separate from its owner,” at the LLC’s election. Id. § 301.7701-3(a)-(b); see McNamee v. Dep’t
of the Treasury, 488 F.3d 100, 107-09 (2d Cir. 2007).
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Williams, with an illegal tax shelter to avoid taxes on his unrelated personal
capital gain of the same approximate amount. The partnerships challenged the
FPAAs by timely filing eleven suits consolidated in the district court pursuant
to 26 U.S.C. § 6226(b)(1). After a bench trial, the district court entered final
judgment and a memorandum opinion upholding the IRS’s disallowance of the
claimed loss and upholding two of the three asserted penalties. Nevada Partners
Fund, LLC ex rel. Sapphire II, Inc. v. United States, 714 F. Supp. 2d 598 (S.D.
Miss. 2010). The partnerships timely appealed and the government cross-
appealed. We affirm in part and vacate in part.
I.
A. The FOCus Program2
James Kelley Williams, an experienced and highly successful Mississippi
businessman, expected to realize a large capital gain in the 2001 tax year—$18
million from the cancellation of Williams’ liability on a loan he had guaranteed.3
Because of this expected gain, Williams conferred with his accountant and tax
advisor, KPMG, LLP, and his attorneys at Baker Donelson, PC. At a meeting
with them on October 2, 2001, KPMG agents gave a PowerPoint presentation to
Williams and his attorneys that described a long-term investment program
offered by Bricolage Capital, LLC (“Bricolage”), called the Family Office
Customized or “FOCus” program. According to the PowerPoint presentation,
the FOCus program had a “structure [that] may result in favorable income tax
2
Because we review the district court’s findings of fact for clear error, we “‘review . . .
the entire record,’” Mo. Pac. R.R. v. R.R. Comm’n of Tex., 948 F.2d 179, 182 (5th Cir. 1991)
(quoting Carr v. Alta Verde Indus., 931 F.2d 1055, 1058 (5th Cir. 1991)), not only the facts
explicitly found or relied upon by the district court.
3
Dollar figures are generally rounded in this opinion for the purpose of clarity.
Kornman & Assoc., Inc. v. United States, 527 F.3d 443, 446 n.3 (5th Cir. 2008); see Cemco
Investors, LLC v. United States, 515 F.3d 749, 750 (7th Cir. 2008).
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consequences [ ] to the investor” and explained that the program was expected
to yield a tax benefit with zero net capital gains and losses.4 The PowerPoint
indicated that the favorable income tax consequences would be approved in a
“‘more likely than not’ tax opinion from Arnold & Porter LLP.” In an internal
memorandum, KPMG referred to this program as an “investment vehicle with
a tax loss-generator possibility for th[at] year.”
The history of the FOCus program can be traced to earlier in 2001.
Bricolage formulated the program for its clients who wished to obtain favorable
tax treatment of certain assets. Bricolage enlisted Credit Suisse-First Boston
(“Credit Suisse”) as the bank that would be essential to the program, which
would involve using LLCs or partnerships in “execut[ing] foreign exchange
transactions in conjunction with a larger tax-motivated transaction . . . that
generates tax losses for clients of Bricolage.” An internal Credit Suisse
memorandum5 concisely set forth how these trades would produce a tax benefit
for the investor:
Clients of Bricolage will invest in an investment partnership that has embedded
losses that have not yet been realized for tax purposes. The clients will
guarantee liabilities of the investment partnership to create sufficient tax basis
to recognize such losses without any limit, and the losses will be triggered and
allocated to the clients. The Transaction results in the allocation of an ordinary
tax loss to an investor that economically did not suffer the loss.
4
The slides that followed showed examples of how the FOCus transaction would work,
claiming, for instance, that with a “[c]apital [l]oss from FOCus investments” perfectly
offsetting an investor’s capital gain, the investor’s net income tax liability would be $0, with
an “[e]xpected tax benefit” of $20 million on a hypothetical $100 million capital gain.
5
The Partnerships argue that we should not consider the Credit Suisse memorandum
because the district court did not “adopt” it in its opinion. However, the district court properly
admitted the memorandum into evidence and, as noted above, our review of the district court’s
factual findings is for clear error, requiring a review of the “whole record.” E.g., Mo. Pac.
R.R., 948 F.2d at 182. We may therefore consider the memorandum.
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As described to Williams in the KPMG PowerPoint, Bricolage’s FOCus
program entailed a three-tiered investment strategy that would produce the
desired deductible tax loss. The first tier of this strategy involved the
investment manager establishing an LLC with a transitory partner to act as a
holding company for other funds (known as a “fund of funds”). The first-tier LLC
would own 99% of a second LLC, which in turn would own 99% of a third LLC.
Initially, the transitory partner would own a 99% interest in the first-tier LLC,
with 1% interest in each LLC held by Bricolage. The two lower-tiered LLCs
would engage in the transactions that would produce the desired tax loss. The
third-tier LLC would enter into sets of currency forward contracts, or “straddle”
trades, that would produce offsetting gains and losses. In the “gain” legs of the
straddle trades, the gains would be realized and reported as income by the 99%
transitory partner; while the losses in the other legs would be suspended in the
books of the third-tier LLC. At that point, the investor-client would purchase
the transitory partner’s interest in the LLCs. The second-tier LLC would then
obtain a Credit Suisse loan guaranteed by the investor that would be used to
engage in a limited-risk foreign currency trade. The investor’s guarantee of the
loan would give him enough basis6 in the LLCs to take advantage of the
embedded loss they had generated.7 Finally, after the investor had offset the
large tax gain with the embedded loss, the FOCus program called for the
6
See 26 U.S.C. § 752(a) (“Any increase in a partner’s share of the liabilities of a
partnership, or any increase in a partner’s individual liabilities by reason of the assumption
by such partner of partnership liabilities, shall be considered as a contribution of money by
such partner to the partnership.”).
7
Taxpayers who choose partnership tax treatment can only deduct losses from their
taxable income to the extent of their basis in the partnership. Klamath Strategic Inv. Fund
ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 542 & n.1 (5th Cir. 2009); see 26
U.S.C. § 731(a)(2) (providing that “loss shall be recognized [only] to the extent of the excess of
the adjusted basis of [a] partner’s interest in the partnership” as adjusted and calculated by
statute).
6
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investor to conduct more traditional investments with Bricolage. In addition to
the foregoing benefits, Bricolage would furnish a legal opinion letter from the
law firm of Arnold & Porter, LLP, approving of the tax treatment of this
investment structure.8
Following Williams’ October 2, 2001, meeting, Bricolage began to carry out
the FOCus strategy described in the PowerPoint presentation. Bricolage utilized
three LLCs in which it already owned interests, Nevada Partners, Carson
Partners, and Reno Partners. They became, respectively, the first-, second-, and
third-tier LLCs in the FOCus Program. The initial transitory 99% owner of
Nevada was Pensacola PFI Corp. (“Pensacola”), an S-corporation whose directors
were two Bricolage principals, Andrew Beer and Samyak Veera. The two
shareholders of Pensacola were two LLCs wholly owned, respectively, by Andrew
Ahn and Jason Chai, two investors with connections to Bricolage. Bricolage
Capital Management Company retained a 1% ownership interest in Nevada and
Carson, and the 1% owner of Reno was Delta Currency Management Co.,
another Bricolage-affiliated company owned by Beer and Veera.9
Pursuant to the FOCus plan, between October and December of 2001,
Reno engaged in foreign currency straddle transactions, which resulted in
approximately eighty closely offsetting loss and gain “legs,” as described in the
FOCus program documents. These trades were conducted through Credit Suisse
and resulted in approximately $18 million in gains and $18 million in losses.10
8
However, when the letter was actually issued in 2002, it stated that “it is more likely
than not that the series of transactions analyzed in this opinion are the same as, or
substantially similar to,” certain transactions the IRS had identified as abusive tax shelters.
The letter simply disagreed with the IRS’ legal assessment of the transactions as tax shelters.
9
Later in November, Pensacola distributed its 99% ownership interest to Ahn and
Chai’s LLCs as a part of the FOCus plan.
10
Initially the straddle trades resulted in $18 million in gains and $17 million in losses,
and the $17 million in losses were embedded by the process described below. However, this
process did not take advantage of all of the loss legs that Reno generated; as described in
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In order to begin the process of separating the corresponding gains and losses,
Pensacola distributed its 99% ownership interest in Nevada to the two LLCs
owned by Ahn and Chai. As more than fifty percent of the interest in Nevada
was sold or exchanged in this transaction, it resulted in the “technical
termination” of Nevada and the lower-tier LLCs for that tax year,11 meaning
that Reno closed its books for tax purposes and reopened them the next day.
Because Reno’s tax year had closed, it was required to declare, or “mark to
market,” certain of the gains and losses on its straddle trades.12 Reno did so, and
the gains flowed up the partnership chain to Ahn and Chai’s LLCs. Ahn and
Chai ultimately reported the gains on their respective tax returns for 2001.
However, because the parties involved in the transaction were “related parties,”
they could only claim the gains from the straddle trades, and could not yet claim
the losses.13 Accordingly, the loss legs were suspended (i.e., not currently
recognized for tax purposes), while the gain legs were reported on the tax
returns of the owners of the transitory partners who evidently could fiscally
further detail below, Reno settled five remaining loss legs in December of 2001, which resulted
in another $1 million in ordinary losses being embedded, for a total of approximately $18
million in losses to offset the $18 million in gains. See id.11
See 26 U.S.C. §§ 708(b)(1)(B), 761(e); see also 26 C.F.R. § 1.708-1(b)(2) (providing
that, if there is a sale or exchange of an interest in an upper-tier partnership that results in
a § 708(b) termination of the upper tier partnership, then the transaction also effects a
technical termination of any lower-tier partnerships).
12
See 26 U.S.C. § 1256. Section 1256 covers foreign currency contracts, which included
a number of the straddle trades Reno had completed. See id. § 1256(b)(1)(B).
13
Id. § 707(b)(1). Section 707(b)(1), “Losses disallowed,” provides, in relevant part: “No
deduction shall be allowed in respect of losses from sales or exchanges of property (other than
an interest in the partnership), directly or indirectly, between—(A) a partnership and a person
owning, directly or indirectly, more than 50 percent of the capital interest, or the profits
interest, in such partnership, or (B) two partnerships in which the same persons own, directly
or indirectly, more than 50 percent of the capital interests or profits interests.”
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absorb them.14 Thus, Bricolage had achieved its first goal of creating an
embedded loss that one of its investor-clients could later claim for tax purposes.
Between October 2, 2001, and December 4, 2001, Williams, through his
attorneys at Baker Donelson, kept in close contact with the Bricolage principals
and KPMG. During that time, he was kept apprised of the LLCs’ progress in
implementing the FOCus steps; he, his son, and his attorney negotiated the
terms of the partnership operating agreement with Bricolage and the fees to be
paid to Bricolage, KPMG, and Arnold & Porter; and he informed Bricolage that
he would need to claim approximately $18 million in losses, including $17
million in capital losses and $1 million in ordinary losses on his 2001 personal
income tax return.
On December 4, 2001, Williams made his initial investment called for by
the FOCus program. Acting on behalf of the JKW 1991 Revocable Trust (“the
Williams Trust”), which held most of Williams’ substantial wealth, Williams
purchased a 99% interest in Nevada Partners from Ahn and Chai’s holding
companies for approximately $883,000. Bricolage retained the remaining 1%
interest. Bricolage was named the “Administrative Member,” giving it the power
and duty to approve any purchase of the Nevada partnerships. Then, on
December 12, 2001, the Williams Trust purchased Nevada’s 99% interest in
Carson Partners for approximately $523,0000, with Bricolage again retaining a
1% interest. Williams became the “Controlling Member” of Carson and retained
decision-making authority. Following this purchase, the Williams Trust
increased its basis in Carson by transferring equity interests and approximately
$1.1 million in cash into Carson. This transaction gave Williams a tax basis in
Carson valued at approximately $9.7 million, slightly more than half of the basis
14
The plaintiffs argue that Ahn and Chai’s tax returns were never formally admitted
into evidence during the bench trial. However, the plaintiffs stipulated to the relevant
information contained therein.
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needed for Williams to take advantage of Carson’s anticipated $18 million
embedded loss.15
In mid-December of 2001, Reno settled five remaining open loss legs,
producing approximately $1 million in ordinary losses. The losses flowed up the
partnership chain to Williams, who reported them as ordinary losses on his 2001
tax return. On December 21, 2001, Carson sold its 99% interest in Reno to
another corporation owned by Bricolage principals for its fair market value of
just under $168,000. This sale triggered a $17 million capital loss for Carson
due to Reno’s embedded loss, which Carson later reported.16 At that time,
Williams had a 99% share of that loss. However, Williams did not yet have
enough basis in Carson to take full advantage of these losses to offset the taxes
on his capital gains.
Thus, the next step was to increase Williams’ basis in Carson so that he
could take advantage of the loss for tax purposes. Consistent with the plan, on
December 20, 2001, Williams signed a personal guarantee of a $9 million loan
from Credit Suisse to Carson for the purpose of engaging in a deep-in-the-money
foreign exchange transaction involving Japanese Yen (JPY).17 This transaction,
15
During the October 2, 2001 presentation, a KPMG agent explained that requiring a
capital commitment equal to fifty percent of the desired loss was necessary to avoid then-
applicable tax-shelter registration requirements. See 26 U.S.C. § 6111(a), (c) (2000).
16
This step was a deviation from the prearranged FOCus scheme. The KPMG
PowerPoint presentation provided that the LLCs would terminate all of the “loss” legs,
triggering the entire amount of desired ordinary losses. Instead, to generate the desired $18
million loss, Reno terminated only five of the loss legs, resulting in $1 million in ordinary
losses, and Carson then triggered the $17 million in capital losses by selling its interest in
Reno. However, as noted above, Williams sought to offset his $17 million in capital gains and
$1 million in ordinary gains. To the extent that the Nevada Partners transactions deviated
from the PowerPoint plan in this respect, the deviation appears to have been consistent with
Williams’ needs.
17
Specifically, Carson borrowed 1,155,600,000 JPY from Credit Suisse, to be repaid on
March 13, 2002 at the “extremely low” annual interest rate of 0.12%. This meant that
Carson’s Yen repayment obligation on that date was about 1,155,905,763 JPY. On the same
day, Carson converted those loan proceeds from the Yen into the U.S. Dollar, which yielded
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known as a “carry trade,” utilized the spread in value between the Japanese Yen
and the U.S. Dollar. During the three-month term of the loan, Carson and
Credit Suisse limited their exposure to exchange-rate fluctuations by means of
a narrow risk “collar,” which ensured that, regardless of the Dollar-Yen
exchange rate on the maturation date, Carson stood to gain at most $77,000 or
to lose at most $90,000. Carson ultimately gained $51,000 on the transactions.
As Dr. Timothy M. Weithers, the government’s expert, explained in his
testimony and report, investment in the Yen at that time in theory made good
economic sense because the Japanese economy was weak and the Yen was
expected to decline. However, as Weithers stated in his report, instead of fully
taking advantage of profits in this economic situation, Carson took an
“unorthodox” approach by imposing the collar, essentially the equivalent of
buying “insurance against a depreciation of the USD (the exact opposite of what
this strategy requires).” Weithers concluded that, without the collar on the Yen
trade, the potential profits would have been many times greater than the
$51,000 earned. Moreover, according to the testimony of Gary Gluck of Credit
Suisse, Williams’ personal guarantee of the loan was not required by the bank
as a condition of the loan because the Carson foreign exchange trade had a very
limited risk exposure (to a maximum of $90,000) due to the collar, and Carson
deposited as collateral an amount sufficient to cover that small risk.18
Nevertheless, Williams, acting on Bricolage’s advice, provided his personal
guarantee anyway so as to increase his basis in Carson by another $9 million.
Williams paid Bricolage a fee of $845,000, a figure that the record suggests
was derived from a negotiated 7% of the $18 million desired loss, less the fees for
$9 million; Carson then used that $9 million to purchase the deep-in-the-money “call spread”
from Credit Suisse, exercisable on March 13, 2002. In effect, the purchased Yen never left the
possession of Credit Suisse.
18
Nevada Partners, 714 F. Supp. 2d at 618.
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Arnold & Porter, KPMG, and funds to be used as collateral for the Yen carry
trades.19 The fee was negotiated between October and December of 2001, and
was paid in early 2002. In April of 2002, Arnold & Porter sent Williams its
engagement letter committing to furnish Williams with its legal opinion. On
October 11, 2002, Arnold & Porter sent Williams two tax opinion letters, one for
him and another for him and Carson, concluding that more likely than not the
tax shelters analyzed therein would survive IRS challenge. Williams claimed
the Reno-Carson embedded loss on his 2001 tax return, which he filed on
October 15, 2002.
From March 2002 forward and in following years, on Bricolage’s
recommendation, Williams made more traditional and straightforward
investments through Carson for profit in hedge funds, foreign exchange, and
private equities. These transactions were not designed to create losses or to
tightly rein in gains, and, consequently, they were very profitable. During this
time, Williams took full advantage of the Dollar-Yen spread, which ultimately
earned him $8 million. From 2002 through 2007, he earned $23 million from
investments in various hedge funds and energy equity funds with Bricolage.
Williams reported and paid the taxes due on those earnings. As the district
court found, “[t]his investment activity was carried on independently of the 2001
FOCus steps.”20
19
As John Beard, Williams’ attorney at Baker Donelson, explained in his testimony:
7% of $18 million is $1.26 million, which was divided as follows: $90,000 (Yen “collar fund”)
+ $225,000 (KPMG’s fee of 1.25% of the $18 million loss) + $100,000 (Arnold & Porter’s fee)
+ $845,000 (Bricolage’s fee from the remaining 7%) = $1.26 million.
20
Id. at 619; see id. at 620, 630-33 (“The evidence clearly shows a division, a line of
demarcation, between the events from December 4, 2001 to December 21, 2001, and the
investment activity that took place after January 1, 2002. Either set of events could have
taken place wholly without the other. . . . [T]he Reno foreign currency straddle and the Carson
foreign currency trades . . . from October to December of 2001 were not part of the highly
successful Yen trading through Carson in which Williams participated after 2002. This
trading was unrelated both in purpose and outcome to the Reno straddle. . . . The FOCus
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B. IRS Tax Shelter Notices and Investigation of FOCus Program
In September of 2000, the IRS issued a notice alerting taxpayers that it
intended to regulate certain abusive tax shelters, see IRS Notice 2000-44, that
were similar in several respects to the FOCus program. The IRS identified
certain arrangements of tiered partnerships to be abusive tax shelter
arrangements because such arrangements are designed to generate artificial tax
losses from foreign currency options transactions.21 IRS Notice 2000-44, entitled
“Tax Avoidance Using Artificially High Basis,” alerted taxpayers that the so-
called “Son of BOSS scheme” had been “‘listed’ as an abusive tax shelter.”22
“Although there are several variants of the Son of BOSS tax shelter[,] . . . they
all rely on the same common principles. ‘Son of BOSS’ uses a series of contrived
steps in a partnership interest to generate artificial tax losses designed to offset
income from other transactions.”23
As this Court recently explained, the “classic Son of BOSS shelter[s] . . .
create[ ] tax benefits in the form of deductible losses or reduced gains by creating
an artificially high basis in partnership interests. Ordinarily under the Internal
Revenue Code, when a partner contributes property to a partnership, the
partner’s basis in his partnership interest increases. When a partnership
assumes a partner’s liability, the partner’s basis decreases. The Son of BOSS
shelter recognizes the increased basis resulting from the partnership’s
plan, as executed through the three-tiered partnerships with the attendant steps, was not
interrelated with . . . Williams’ subsequent investment activity with Bricolage. Instead, . . .
the F[OC]us steps and the subsequent investment activity with Bricolage were separate
events, not dependent upon each other, and neither requiring the other to proceed.”).
21
Id.; see Kornman, 527 F.3d at 446 n.2 (describing the “BOSS” and “Son of BOSS”
shelters).
22
Kornman, 527 F.3d at 446 n.2. “‘BOSS’ is an acronym for ‘Bond and Option Sales
Strategy[.]’” Id.23
Id. (citations and internal quotation marks omitted).
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acquisition of the partner’s asset, but ignores the effect on that basis created by
the partnership’s assumption of the partner’s liability. A higher basis can lead
to the recognition of a loss or a reduced amount of gain when the asset is sold.”24
Due to these features, Son of BOSS is a well-recognized “abusive” tax shelter.25
On April 21, 2002, the IRS compelled KPMG to disclose all information
about and all persons participating in FOCus programs. Then, on June 27, 2002,
the IRS issued Notice 2002-50, entitled “Partnership Straddle Tax Shelter.” The
notice “advise[d] taxpayers and their representatives that the described
transaction, which uses a straddle, a tiered partnership, a transitory partner
and the absence of a section 754 election to obtain a permanent non-economic
loss, is subject to challenge by the Service on several grounds. The notice holds
that the described transaction is now a ‘listed transaction’ and warns of the
potential penalties that may be imposed if taxpayers claim losses from such a
transaction,” and that the transactions will be disregarded if they lack “economic
substance.” Notice 2002-50, 2002-28 I.R.B. 98, 2002-2 C.B. 98.
On October 11, 2002, several months after Notice 2002-50 was issued,
Arnold & Porter sent Carson and Williams the “more likely than not” legal
opinion letters as stipulated in the KPMG PowerPoint presentation promoting
the FOCus program and investment package.26 The letter addressed to Williams
stated that, in the firm’s “opinion, it is more likely than not that the series of
transactions analyzed in this opinion are the same as, or substantially similar
24
Bemont Invs., L.L.C. ex rel. Tax Matters Partner v. United States, 679 F.3d 339,
341-42 (5th Cir. 2012) (citing 26 U.S.C. §§ 722, 752).
25
See id. at 342, 344 (citing IRS Notice 2000-44, 2000-36 I.R.B. 255, 2000-2 C.B. 255(Sept. 5, 2000)); Kornman, 527 F.3d at 446 n.2.
26
One letter was addressed to Carson Partners Fund, LLC, and the other was
addressed to Williams as Trustee for the Williams Trust. The salutation in both letters was
directed to “Mr. Williams,” and both letters sent in care of Williams’ attorney at Baker
Donelson.
14
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to, the listed transaction described in Notice 2002-50.” Nonetheless, the Arnold
& Porter tax opinions do not attempt to distinguish the FOCus transactions from
those described by Notice 2002-50 or to address how the Notice could affect a
court’s analysis of the transactions. The letter simply recommended that the
transactions described in the letter “more likely than not” had economic
substance. The partnerships filed their eleven Form 1065 partnership
information returns between March and October of 2002 reporting the embedded
loss from the sale of Reno.27 On October 15, 2002, Williams filed his individual
tax return claiming the deduction for the embedded loss.28
In 2006, the IRS issued FPAA notices pursuant to 26 U.S.C. § 6223 for
each of eleven separate partnership tax returns for the corporate tax periods
ending in November through December of 2001.29 Those FPAAs asserted that
the FOCus program transactions were a sham intended to generate a tax loss for
Williams:
Nevada Partners Fund, LLC . . . was formed and availed of solely for purposes
of tax avoidance and, in furtherance of such purpose, engaged in a prearranged
transaction, designed and executed through a series of meaningless steps, using
a straddle, a tiered partnership structure, a transitory partner, and the absence
of a Section 754 election to allow a tax shelter investor to claim a permanent
non-economic loss. . . . [T]he series of steps comprising the Transaction,
including the creation of [Nevada, Carson, and Reno,] . . . and the purchase and
sale of foreign currency contracts and positions was a sham, lacked economic
substance, and was not engaged in for a legitimate business purpose.
27
Three of the partnerships’ 1065 Forms were marked received by the IRS on March
18, 2002; three were marked received on April 17, 2002; and the remaining five were marked
received between October 18 and 21, 2002.
28
As of December 31, 2004, Sapphire II, a Mississippi corporation owned by Williams
and his two brothers, purchased Bricolage’s interest in Nevada and Carson and replaced
Bricolage as the Administrative Member. Accordingly, Sapphire II is a named party to this
appeal, but that transaction is not at issue in the case.
29
Bemont, 679 F.3d at 340 (“An FPAA is the partnership equivalent of a statutory
notice of deficiency to an individual or non-partnership entity.”).
15
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Accordingly, the FPAAs disallowed the losses claimed by the partnerships
and, in turn, by Williams, under the economic substance doctrine, which, in
short, “allows courts to enforce the legislative purpose of the [Internal Revenue]
Code by preventing taxpayers from reaping tax benefits from transactions
lacking in economic reality.”30
In the alternative, the IRS asserted that under Treasury Regulation
§ 1.701-2, it could shift the $18 million gain from the Reno foreign exchange
straddle transactions, which were realized in November before Williams was a
partner, to Williams individually. The FPAAs also assessed three alternative
penalties under 26 U.S.C. § 6662: one for negligence and one for substantial
understatement, both of which carried a 20% penalty based on the
underpayment; and a third for gross valuation misstatement, which carried a
40% penalty.
C. District Court Proceedings
The plaintiffs filed eleven actions in the United States District Court for
the Southern District of Mississippi challenging each FPAA and penalty. The
cases were consolidated and tried in a bench trial. The district court heard
testimony from numerous witnesses over several weeks, and in a seventy eight-
page memorandum opinion and order dated April 30, 2010, the district court
upheld the adjustments and two of the three penalties asserted in the FPAAs.
The court concluded that the multi-step FOCus program lacked economic
substance and was intended only to provide Williams with a tax shelter. The
court also upheld the IRS’s reliance on Treasury Regulation § 1.701-2 as
authority to attribute the relevant tax-related transactions to Williams. With
regard to the penalties, the court upheld the negligence and substantial
30
Klamath, 568 F.3d at 543.
16
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understatement penalties (while recognizing that these penalties were not
cumulative, i.e., they could not be “stacked”) and rejected the plaintiffs’
substantial authority and reasonable cause defenses. However, the court
disallowed the 40% valuation misstatement penalty, citing this Court’s
Todd–Heasley rule disallowing that penalty where the relevant deduction has
been totally disregarded because the underlying transaction lacked economic
substance.31 The district court entered judgment sustaining the IRS’s position
in each of the eleven FPAAs but disallowing the 40% penalty.
The plaintiffs moved to amend the district court’s judgment to reflect a
dismissal of their claims as to only eight of the eleven FPAAs. They argued that
the judgment, as entered, effectively imposed a double tax because eight of the
FPAAs disallowed the losses as lacking in economic substance, while the
remaining three FPAAs would have held Williams responsible for the gains. The
plaintiffs argued that judgment in the actions challenging the three “gain”
FPAAs should be rendered in their favor because they were premised on the
IRS’s alternative argument—namely, that, if the transactions did have economic
substance, then the partnerships’ gains on the transactions should be reallocated
to Williams and taxed even though they fell outside the period in which he had
an ownership interest in the partnerships, pursuant to the Treasury
Regulations’ “anti-abuse rule.”32 The government opposed the motion on
procedural grounds but conceded that in substance it did not seek to collect taxes
from the partnerships on both its principal theory (lack of economic substance)
and its alternative theory (Treasury Regulation § 1.701-2). The district court
31
See Heasley v. Comm’r, 902 F.2d 380, 383 (5th Cir. 1990); Todd v. Comm’r, 862 F.2d
540, 542-44 (5th Cir. 1988).
32
See 26 C.F.R. § 1.701–2 (anti-abuse rule).
17
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denied the motion. The partnerships timely appealed,33 and the government
cross-appealed the district court’s denial of a larger penalty.34
II.
A. Economic Substance Doctrine35
Our economic substance analysis begins with Gregory v. Helvering, 293
U.S. 465 (1935), “the Supreme Court’s foundational exposition of economic
substance principles under the Internal Revenue Code.” ACM P’ship v.
Comm’r,157 F.3d 231, 246 (3d Cir. 1998). In Gregory, the taxpayer engaged in
a series of transactions which were technically consistent with the Internal
Revenue Code but which lacked any real economic substance and defeated the
purpose of the Code provisions. 293 U.S. at 467-70. The taxpayer attempted to
avoid paying taxable dividends on stock transfers from her wholly-owned
corporation by first creating a new corporation to which she transferred the
stock, and then liquidating the new corporation and transferring the stock to
herself. Id. at 467-68. She claimed that the transaction did not create taxable
33
See 26 U.S.C. § 6226(b)(1); Fed. R. App. P. 4(a)(4)(A)(iv).
34
Jurisdiction was proper in the district court pursuant to 28 U.S.C. § 1346(e).
Jurisdiction to review partnership proceedings is limited to the determination of partnership
items, as well as penalties and defenses asserted on behalf of the partnership. See 26 U.S.C.
§§ 6221, 6226(f); Klamath, 568 F.3d at 547-48. We have jurisdiction to review the final
judgment of the district court. See 26 U.S.C. § 6226(g); 28 U.S.C. § 1291.
35
Subsequent to the events giving rise to this lawsuit, Congress passed a law codifying
the economic substance doctrine, which became effective after the district court issued its
opinion in this case. See Health Care and Education Reconciliation Act of 2010, Pub. L. No.
111-152 § 1409, at *1067-68, codified at 26 U.S.C. § 7701(o) (“Clarification of economic
substance doctrine.”). The Act also effected numerous other changes, including to the
application of the gross valuation misstatement penalty and the reasonable cause defense. See
generally id. at *1067-70. The 2010 amendments apply “to transactions entered into after the
date of the enactment of th[e] Act,” on December 17, 2010. Id. at *1070. No one contends that
the revisions apply in this case, and we do not consider them.
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dividends because she had received the stock “‘in pursuance of a plan of
reorganization’” within the meaning of the Internal Revenue Code. Id. at 468-69(citation omitted). Although the transactions technically fell within the
definition of a corporate reorganization, which normally would have meant that
the transfers were exempt from taxation, the Court held that the IRS could
collect tax on the dividends. Id. at 469-70. The Court explained that “[t]he
whole undertaking, though conducted according to the terms [of the statute],
was in fact an elaborate and devious form of conveyance masquerading as a
corporate reorganization” and as such it defeated the “plain intent” of the
Internal Revenue Code. Id. at 470. Therefore, pursuant to Gregory, to
determine whether a claimed deduction “exalt[s] artifice above reality,” id., we
“‘look beyond the form of [a] transaction’ to determine whether it has the
‘economic substance that its form represents,’” ACM P’ship, 157 F.3d at 247(citation and alteration omitted); accord Freytag v. Comm’r, 904 F.2d 1011, 1015
(5th Cir. 1990) (“The fundamental premise underlying the Internal Revenue
Code is that taxation is based upon a transaction’s substance rather than its
form. Thus sham transactions are not recognized for tax purposes, and losses
allegedly generated by such transactions are not deductible.”), aff’d on other
grounds, 501 U.S. 868 (1991).
The Supreme Court has explained that a “natural conclusion” of its
holding in Gregory was that transactions that “do not vary control or change the
flow of economic benefits[ ] are to be dismissed from consideration.” Higgins v.
Smith, 308 U.S. 473, 476 (1940); accord Coltec Indus., Inc. v. United States, 454
F.3d 1340, 1355 (Fed. Cir. 2006). This Court, the Federal Circuit, and other
Courts of Appeals have followed a similar approach. See Klamath, 568 F.3d at
543.36 In Klamath, we observed that a split existed among other circuits
36
Accord, e.g., Coltec, 454 F.3d at 1353-54 (Federal Circuit); Dow Chem. Co. v. United
States, 435 F.3d 594, 599 (6th Cir. 2006); Boca Investerings P’ship v. United States, 314 F.3d
19Case: 10-60559 Document: 00512284556 Page: 20 Date Filed: 06/24/2013
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regarding when a transaction should be disregarded as lacking economic reality.
See id. We did not follow the Fourth Circuit’s “rigid two-prong test, where a
transaction will only be invalidated if it lacks economic substance and the
taxpayer’s sole motive is tax avoidance.” Id. at 544 (citing Rice’s Toyota World,
Inc. v. Comm’r, 752 F.2d 89, 91-92 (4th Cir. 1985)) (emphasis added). Instead,
we adopted the majority view, which “is that a lack of economic substance is
sufficient to invalidate the transaction regardless of whether the taxpayer has
motives other than tax avoidance.” Id. (citations omitted). We concluded that
the majority view more accurately interprets the Supreme Court’s prescript in
Frank Lyon Co. v. United States, 435 U.S. 561 (1978), which addressed the
factors courts should consider when assessing whether a transaction lacks
economic substance. Klamath, 568 F.3d at 544.
We derived from Frank Lyon a “multi-factor test for when a transaction
must be honored as legitimate for tax purposes,” including whether the
transaction: “(1) has economic substance compelled by business or regulatory
realities, (2) is imbued with tax-independent considerations, and (3) is not
shaped totally by tax-avoidance features.” Klamath, 568 F.3d at 544. “In other
words, the transaction must exhibit objective economic reality, a subjectively
genuine business purpose, and some motivation other than tax avoidance.”
Southgate Master Fund, LLC ex rel. Montgomery Capital Advisors, LLC v.
United States, 659 F.3d 466, 480 (5th Cir. 2011). “Importantly, these factors are
phrased in the conjunctive, meaning that the absence of any one of them will
render the transaction void for tax purposes. Thus, if a transaction lacks
economic substance compelled by business or regulatory realities, the
transaction must be disregarded even if the taxpayers profess a genuine
business purpose without tax-avoidance motivations.” Klamath, 568 F.3d at
625, 631 (D.C. Cir. 2003); In re CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002); United
Parcel Serv. of Am., Inc. v. Comm’r, 254 F.3d 1014, 1018 (11th Cir. 2001).
20
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544. “While ‘these factors are phrased in the conjunctive,[’] . . . there is
near-total overlap between the latter two factors. To say that a transaction is
shaped totally by tax-avoidance features is, in essence, to say that the
transaction is imbued solely with tax-dependent considerations.” Southgate, 659
F.3d at 480 & n.40 (quoting Klamath, 568 F.3d at 544).
“[W]hen applying the economic substance doctrine, the proper focus is on
the particular transaction that gives rise to the tax benefit, not collateral
transactions that do not produce tax benefits.” Klamath, 568 F.3d at 545. “As
to the first Klamath factor, transactions lack objective economic reality if they
‘do not vary, control, or change the flow of economic benefits.’” Southgate, 659
F.3d at 481 (citation and alteration omitted). “The objective economic substance
inquiry asks whether the transaction affected the taxpayer’s financial position
in any way.” Id. at 481 n.41 (citation, quotation marks, and alterations omitted).
“This is an objective inquiry into whether the transaction either caused real
dollars to meaningfully change hands or created a realistic possibility that they
would do so[,]” meaning “‘a reasonable possibility of profit from the transaction
existed apart from tax benefits.’” Id. at 481 & n.43 (citation and other footnote
omitted). “That inquiry must be ‘conducted from the vantage point of the
taxpayer at the time the transactions occurred, rather than with the benefit of
hindsight.’” Id. at 481 (citation omitted).
When considering whether a transaction lacks economic substance and
thus should be disregarded for tax purposes, courts have given close scrutiny to
arrangements with subsidiaries that do not affect the economic interest of
independent third parties. See Southgate, 659 F.3d at 481 n.42 (“A circular flow
of funds among related entities does not indicate a substantive economic
transaction for tax purposes.”) (citation, quotation marks, and alteration
omitted); see also, e.g., Frank Lyon, 435 U.S. at 575, 583 (holding that a “genuine
multiple-party transaction” had economic substance, and distinguishing more
21
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“familial” arrangements involving only two parties); Gregory, 293 U.S. at 469(concluding that the transfer of stock from a wholly owned corporation to a newly
created corporation, and then directly to the taxpayer, lacked economic
substance because the “sole object and accomplishment of [the transfer] was the
consummation of a preconceived plan, not to reorganize a business . . . but to
transfer a parcel of corporate shares to the petitioner”); Coltec, 454 F.3d at 1360(“[T]he transaction here could only affect relations among Coltec and its own
subsidiaries—it has absolutely no [e]ffect on third party . . . claimants.”); United
Parcel Serv. of Am., 254 F.3d at 1018-19 (concluding that a transaction had
economic substance because it created “genuine obligations enforceable by an
unrelated party” that was not under the taxpayer’s control).
Finally, the Supreme Court has noted that “an income tax deduction is a
matter of legislative grace and that the burden of clearly showing the right to
the claimed deduction is on the taxpayer.” INDOPCO, Inc. v. Comm’r, 503 U.S.
79, 84 (1992) (citations omitted); accord, e.g., Arevalo v. Comm’r, 469 F.3d 436,
440 (5th Cir. 2006). Accordingly, “when [a] taxpayer claims a deduction, it is the
taxpayer who bears the burden of proving that the transaction has economic
substance.” Coltec, 454 F.3d at 1355. A notice of deficiency issued by the IRS
is “generally given a presumption of correctness, which operates to place on the
taxpayer the burden of producing evidence showing that the Commissioner’s
determination is incorrect.” Sealy Power, Ltd. v. Comm’r, 46 F.3d 382, 387 (5th
Cir. 1995).
22
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B. Economic Substance Vel Non of the FOCus Transactions
The district court’s ultimate conclusion as to whether a transaction has
economic substance is a question of law we review de novo, but we review the
particular facts from which that characterization is made for clear error.
Southgate, 659 F.3d at 480; Klamath, 568 F.3d at 543. Measured by these
standards, we see no error of law or clear error of fact in the district court’s
decision.
Applying the foregoing economic substance doctrine principles, we
conclude that the district court did not err legally or factually in determining
that the partnerships failed to meet their burden of proving that the
transactions giving rise to the $18 million tax loss in question had economic
substance. The district court correctly held that the multi-step FOCus strategy
carried out in conjunction with the three-tiered partnership structure of Nevada,
Carson, and Reno between October and December of 2001 lacked economic
substance and served no other purpose than to provide the structure through
which Williams could enjoy the reduction of his tax burden for that year.
Accordingly, the district court correctly concluded that the FOCus transactions
must be disregarded for tax purposes, and that in their absence the $18 million
embedded loss in Reno and Carson was correctly disallowed by the IRS. The
district court in making these determinations correctly analyzed the FOCus
transactions that gave rise to the tax benefit at issue and correctly rejected the
partnerships’ argument that the court should consider the FOCus transactions
as part of Williams’ subsequent, highly profitable investments with Bricolage
from mid-2002 through 2007.
The record shows that the 2001 Reno foreign currency straddles, the pre-
March 2002 Carson Yen carry trades, and Williams’ personal guarantee of the
Credit Suisse loan to Carson, viewed objectively, were not designed to make a
profit, but were used to create an $18 million loss; to separate the gains from
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that loss by allocating the gains to the transitory owners of Carson, to embed the
loss on Carson’s books; to allow Williams to acquire Carson along with its
embedded $18 million loss; and ultimately to allow him to acquire, by his loan
guarantee, the rest of his $18 million basis in Carson that he needed to claim the
loss as a deduction against his unrelated $18 million personal capital gain.37
Altogether, those were the transactions that enabled Williams with some
plausibility to claim Carson’s embedded loss of $18 million as a deduction on his
individual 2001 income tax return. None of those key transactions had economic
substance because they were designed to serve no other purpose than to provide
the structure through which Williams could enjoy the $18 million reduction of
his personal 2001 tax burden.
Further, the key FOCus transactions were conducted among several
related entities and even the trades with third persons were engineered to avoid
producing any meaningful profits or losses apart from the artificial loss
embedded in Reno and Carson that gave rise to Williams’ tax benefit. See, e.g.,
Southgate, 659 F.3d at 481 n.42 (“A circular flow of funds among related entities
does not indicate a substantive economic transaction for tax purposes.”) (citation,
quotation marks, and alteration omitted); Frank Lyon, 435 U.S. at 575(suggesting that “familial” arrangements, in contrast with “genuine
multiple-party transaction[s],” are more likely to lack economic substance);
Coltec, 454 F.3d at 1360 (concluding transaction that had “absolutely no [e]ffect
on third party . . . claimants” lacked economic substance).
We agree with the district court’s assessment, based in part on the
persuasive testimony of the government’s expert, Dr. Timothy Weithers, that the
37
As noted above, supra n.15, according to the FOCus program, a capital commitment
of fifty percent of the desired loss was necessary to avoid then-applicable tax-shelter
registration requirements. See 26 U.S.C. § 6111(a), (c) (2000). Accordingly, half of Williams’
basis was created by his capital investment in Carson, and the rest of Williams’ basis was
created by his unsolicited guarantee of the $9 million loan to Carson.
24
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2001 Reno straddle trades had no objective possibility of making a meaningful
overall profit or of appreciably affecting the beneficial interest—aside from tax
avoidance—of either Williams or the partnerships. The straddles produced
almost precisely offsetting gains and losses; as Weithers explained, those trades
“involved little or no real market exposure, with virtually no likelihood of
generating significant positive or negative returns.” Reno and Credit Suisse
followed a plan calculated to ensure those closely offsetting results by invariably
unwinding each straddle within one or two business days, and with the same
exchange rate exposure, to lock in the virtually offsetting gains and losses that
typically result from exchange rate fluctuations within such short periods.
The partnerships argue that straddle trades are often used to make a
profit, citing the report and testimony of their expert witness. The partnerships
contend that an investor could reasonably profit after having bought both an
option to purchase (a “call”) and an option to sell (a “put”) in the same commodity
or currency by exercising whichever of the two would generate a higher net gain.
Indeed, both parties’ experts recognized that straddle trades are a relatively
common investment strategy and can in theory generate a profit.38 However,
the Reno straddle trades, as designed and carried out, simply could not produce
38
A straddle creates a potential for profit as follows: If the commodity increases in
price beyond the strike price of the buy option or call, the buyer can exercise the call and reap
the net gain between the strike price and the actual price of the commodity. The investor
makes a profit where this net gain is more than the amount he or she paid for the options to
buy and sell. Conversely, if the commodity price decreases below the strike price for the sell
option or put, the investor can exercise the put, and sell the commodity at the strike price,
which is then above the actual price of the commodity. Again, the investor is rewarded with
the net gain between the actual and strike prices, and if that gain is more than he paid for the
options, the investor makes a profit. Thus, a straddle rewards the investor only when the
commodity fluctuates enough in price, either up or down, to make the net gain on the call or
the put option more than the cost of the options. In the present case, however, the strategy
called for the exercise of both the call and the put, and within such short periods as to produce
virtually offsetting gains and losses. See generally, e.g., Freytag, 904 F.2d at 1013 n.1; Miller
v. Comm’r, 836 F.2d 1274, 1276-77 (10th Cir. 1988); Yosha v. Comm’r, 861 F.2d 494, 495-97
(7th Cir. 1988).
25
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a profit; they were calculated and managed to produce offsetting gains and
losses. Rather than choosing and timing the exercise of the more profitable leg
of each trade, or by purchasing options that hedged meaningfully different
positions in the same currency over time, the FOCus strategy was to exercise
both the call and the put within at most a two-day period using options with the
same market exposure rate, which generated virtually equal-and-opposite gains
and losses within a short period. Cf. United States v. Atkins, 869 F.2d 135, 137-
38 (2d Cir. 1989) (affirming criminal convictions for wilful tax evasion of traders
who engaged in straddle trades engineered to avoid the possibility of any risks
or gains due to market fluctuations and created for the sole purpose of
generating artificial tax-deductible losses for their clients). As this Court
explained in Klamath, the theoretical possibility for profit in a particular type
of transaction is beside the point when the transaction—as it was actually
carried out—lacked such a possibility. See 568 F.3d at 545. By the time
Williams invested in the FOCus partnerships, the gains from the Reno straddle
trades had already been absorbed by Carson’s transitory owners, and all that
remained from the straddle trades was the equal and opposite multi-million
dollar loss on Reno’s, and then Carson’s, books. Williams was simply allowed,
for a fee, to purchase a partnership holding a large tax loss for use as a
deduction against his unrelated income. There was no possibility of net profit
in the Reno straddle transactions.
Likewise, Williams’ personal guarantee of Credit Suisse’s $9 million loan
to Carson had no economic substance. The personal guarantee was not required
by the bank as a condition of the loan and did not further any non-tax related
business objective of Williams or the partnerships. It was essentially gratuitous
and designed only to increase Williams’ tax basis in Carson so that he could
claim Carson’s embedded loss as a deduction. In sum, the transactions that
created Carson’s $18 million embedded loss had no economic substance and
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Williams obtained the benefit of an $18 million deduction on his 2001 personal
income tax return without suffering any real economic loss.
The partnerships also argue that the Carson Yen carry trade maturing in
March of 2002 had economic substance because it ended with a slight credit
balance of approximately $51,000. This argument is without merit for several
reasons. First, the tax benefit claimed by Williams stemmed from the Reno
straddle trades, not from the Carson Yen carry trade. See Klamath, 568 F.3d at
545 (“[W]hen applying the economic substance doctrine, the proper focus is on
the particular transaction that gives rise to the tax benefit, not collateral
transactions that do not produce tax benefits.”) The particular transactions that
gave rise to the tax loss benefit were generated by the Reno straddle trades, not
the Carson Yen carry trade. Because the straddle transactions lacked economic
substance, the $18 million artificial loss must be disregarded for tax purposes
regardless of whether Carson’s March 2002 Yen carry trade was entered into for
profit.
Moreover, the record supports the district court’s conclusion that the
Carson Yen trade was by design not entered into for profit, either. In the Yen
transaction, Carson limited its exposure to exchange-rate fluctuations by means
of a narrow risk “collar,” which ensured that Carson stood to gain at most
$77,000 or to lose at most $90,000—by design a relatively insignificant range in
comparison with the $18 million tax benefit, the $9 million loan used for the
trades, and the substantial fees and expenses incurred in the course of the
FOCus program.39 As the Supreme Court has put it in a comparable situation,
it was a “relative pittance” that did “‘not appreciably affect [the] beneficial
39
The fees and transactional expenses included, for example, Bricolage’s fee ($845,000),
Arnold & Porter’s fee ($100,000), KPMG’s fee ($225,000), collateral for the Yen trade ($90,000),
the cost of buying the LLCs, transactional costs associated with selling Reno, trade
commissions, and personnel costs. See supra n.19.
27
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interest[.]’” Knetsch v. United States, 364 U.S. 361, 366 (1960) (quoting Gilbert
v. Comm’r, 248 F.2d 399, 411 (2d Cir. 1957) (Learned Hand, J., dissenting));
accord, e.g., Keeler v. Comm’r, 243 F.3d 1212, 1214-15 (10th Cir. 2001)
(concluding a taxpayer’s “straddle” trades of stock positions lacked economic
substance because the “trading program” offered “only illusory opportunity for
economic profit” and any potential profit was “anemic beside [the] considerable
capacity for tax gaming”). We agree that the purpose of the collared transaction
was not to make a profit but to “mak[e] Carson and Nevada appear gainfully
employed,” Nevada Partners, 714 F. Supp. 2d at 632, while generating the
embedded loss and providing a pretext for Williams to increase his basis in
Carson (through his gratuitous personal guarantee of the loan) so that he could
take full advantage of the embedded loss. The $51,000 amount gained in this
transaction was not shown to have been a net profit on an investment but rather
was within the range of operational expenses or gains assumed as a byproduct
of the design of the transactions, which, viewed objectively, were prearranged
so as to avoid undertaking a meaningful risk or realizing a meaningful net profit
or loss.
Finally, the partnerships contend that the transactions had economic
substance because the FOCus program represented the preliminary stage of an
integrated long-term investment program by Williams with Bricolage that
ultimately earned Williams $8 million from Yen carry trades from March 2002
forward, and $23 million from other types of investments from mid 2002 to 2007.
As the district court reasonably found, however, the transactions giving rise to
the tax loss benefit, the 2001 Reno straddle trades, were distinct from the
subsequent profitable investments from March 2002 forward. Correspondingly,
the highly profitable investments by the Williams family with Bricolage from
mid 2002 to 2007 did not give rise to the 2001 tax loss at issue in this
case. Thus, the district court did not err in finding that the FOCus artificial
28
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loss-creation plan simply was not “interrelated with” the subsequent for-profit
investment activity; instead, they were “separate events, not dependent upon
each other, and neither requiring the other to proceed.” Nevada Partners, 714
F. Supp. 2d at 633; see Sala v. United States, 613 F.3d 1249, 1250, 1252-54 (10th
Cir. 2010) (holding that the IRS properly disallowed deductions due to their lack
of economic substance where the taxpayer participated in “an investment
program that included an initial phase designed primarily to generate a tax loss
so as to offset” otherwise taxable income and the transactions giving rise to the
tax benefit were separable from the follow-on investment plan), cert. denied, 132
S. Ct. 91 (2011).
The record as a whole supports the district court’s factual findings, and the
plaintiffs do not present a cogent reason why we should be left with a firm and
definite conviction that a mistake has been made. See Anderson v. City of
Bessemer City, 470 U.S. 564, 573-74 (1985). For these reasons, we conclude that
the district court did not err in deciding that the partnerships did not carry their
burden of proving that the transactions that gave rise to the tax loss in question
had economic substance.40
III.
Finally, having decided that the FOCus transactions must be disregarded
for federal income tax purposes, we have jurisdiction to review the district
court’s determinations regarding the penalties assessed against the partnerships
40
Because we conclude that the transactions lacked economic substance under the
objective prong of the Klamath inquiry, we need not and do not also consider whether the
transactions had subjectively “genuine business purpose without tax-avoidance motivations.”
Klamath, 568 F.3d at 544. As discussed above, the objective and subjective factors are
conjunctive, “meaning that the absence of any one of them will render the transaction void for
tax purposes.” Id.; accord Southgate, 659 F.3d at 480.
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by the IRS. See Klamath, 568 F.3d at 547-48; 26 U.S.C. § 6226(f); accord Am.
Boat Co., LLC v. United States, 583 F.3d 471, 478 (7th Cir. 2009).
Section 6662 of the Internal Revenue Code in effect in 2001 authorizes the
IRS to levy a penalty equal to 20% of the portion of any underpayment of tax
attributable to, inter alia, the following: (i) negligence or disregard of rules or
regulations; (ii) substantial understatement of income tax; and (iii) substantial
valuation misstatement.41 The IRS assessed a penalty against the partnerships
under each of these three provisions. However, because penalties under § 6662
must be applied alternatively, not cumulatively, only one of the penalties
assessed may be sustained—they cannot be stacked. See Southgate, 659 F.3d at492 n.81; Bemont, 679 F.3d at 346.
The district court reversed the penalty for substantial valuation
misstatement in accord with our decisions in Todd v. Commissioner, 862 F.2d
540 (5th Cir. 1988) and Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990),
holding that a valuation misstatement penalty is not applicable where an entire
transaction is disregarded under the economic substance doctrine. Because this
panel, like the district court, is bound by our circuit precedents in Todd and
Heasley,42 we will affirm the district court’s judgment in this respect without
added discussion here. For the reasons hereinafter assigned, we conclude that
the negligence penalty was correctly assessed and affirmed by the district court.
41
The valuation-misstatement penalty authorized increases to 40% in the case of a
gross valuation misstatement. 26 U.S.C. §§ 6662(e)(1)(B)(i), 6662(h)(1)-(h)(2)(A)(ii) (2000).
42
See Bemont, 679 F.3d at 351-55 (Prado, J., specially concurring, joined by Reavley &
Davis, JJ.) (same); see also Hill v. Carroll Cnty., 587 F.3d 230, 237 (5th Cir. 2009) (“[A] later
panel of this court cannot overrule an earlier panel decision.”). Although the Supreme Court
has granted certiorari in Woods v. United States, 471 F. App’x 320 (5th Cir. 2012) (addressing
the application of the 40% penalty and this Court’s Todd–Heasley rule), see Woods v. United
States, No. 12-562, 2013 WL 1187584 (Mar. 25, 2013), “[a]bsent an intervening Supreme Court
case overruling prior precedent, we remain bound to follow our precedent even when the
Supreme Court grants certiorari on an issue[,]” United States v. Lopez–Velasquez, 526 F.3d
804, 808 n.1 (5th Cir. 2008).
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Because but one 20% penalty may stand, we will affirm the district court’s
approval of the negligence penalty and vacate its approval of the substantial
understatement of income tax penalty without needless discussion of that
alternate basis for the penalty.
A. The Partnerships’ Negligence
We review a lower court’s “findings of negligence under the clearly
erroneous rule.” Streber v. Comm’r, 138 F.3d 216, 219 (5th Cir. 1998); accord,
e.g., Masat v. Comm’r, 784 F.2d 573, 577 (5th Cir. 1986). “Clear error exists
when this court is left with the definite and firm conviction that a mistake has
been made.” Streber, 138 F.3d at 219. “The taxpayer bears the burden of
establishing the absence of negligence.” Reser v. Comm’r, 112 F.3d 1258, 1271
(5th Cir. 1997); accord, e.g., Zmuda v. Comm’r, 731 F.2d 1417, 1422 (9th Cir.
1984) (“The taxpayer has the burden of establishing that the penalty was
erroneous.”); see also, e.g., INDOPCO, Inc., 503 U.S. at 84 (“[T]he burden of
clearly showing the right to the claimed deduction is on the taxpayer.”); Arevalo,
469 F.3d at 440 (“Taxpayers bear the burden of proving their entitlement to
deductions.”).
Section 6662 of the Internal Revenue Code imposes the 20% penalty
attributable to “[n]egligence or disregard of rules or regulations.” 26 U.S.C.
§ 6662(b)(1). “Negligence” can include any failure to make a reasonable attempt
to comply with the provisions of the Code, to exercise ordinary and reasonable
care in the preparation of a tax return, to keep adequate books and records, or
to substantiate items properly. 26 U.S.C. § 6662(c); 26 C.F.R. § 1.6662-3(b)(1).
Negligence for this purpose is defined by the “reasonable and prudent person”
standard. 26 C.F.R. § 1.6662-3(b)(1)(ii); Bemont, 679 F.3d at 348; accord, e.g.,
Sandvall v. Comm’r, 898 F.2d 455, 458 (5th Cir. 1990) (applying standard to
prior version of statute); Marcello v. Comm’r, 380 F.2d 499 (5th Cir. 1967)
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(same). “Generally speaking, the negligence standard as in the tort context is
objective, requiring a finding of a lack of due care or a failure to do what a
reasonable and prudent person would do under analogous circumstances.” See,
e.g., Neonatology Assocs., P.A. v. Comm’r, 299 F.3d 221, 233 (3d Cir. 2002) (citing
Schrum v. Comm’r, 33 F.3d 426, 437 (4th Cir. 1994)).
On the basis of the record, the district court was justified in concluding as
a matter of fact that the partnerships were negligent and exposed themselves to
liability for the § 6662 accuracy-related penalties because they did not meet their
burden of proving due care and the absence of negligence. See Goldman v.
Comm’r, 39 F.3d 402, 407 (2d Cir. 1994) (“Once the Commissioner determines
that a negligence penalty is appropriate, the taxpayer bears the burden of
establishing the absence of negligence.”). The evidence supports the district
court’s findings that the persons acting in behalf of the partnerships knew that
their 2001 FOCus transactions lacked economic substance and would create an
artificial loss that would later be used by Williams, who suffered no matching
economic loss, to take a “too good to be true’’43 $18 million deduction against his
unrelated 2001 personal capital gain of the same amount. See Neonatology
Assocs., 299 F.3d at 234 (“When, as here, a taxpayer is presented with what
would appear to be a fabulous opportunity to avoid tax obligations, he should
recognize that he proceeds at his own peril.”). The partnerships did not
introduce any evidence to prove that, before they engaged in the FOCus
transactions between November and December 2001, they made a proper
investigation or exercised due diligence to verify the tax legitimacy of the
proposed FOCus transactions at issue.
43
26 C.F.R. § 1.6662-3(b)(1)(ii) (“Negligence is strongly indicated where . . . [a] taxpayer
fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or
exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to
be true’ under the circumstances.”).
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Further, the persons involved in promoting and setting up the
partnerships’ 2001 FOCus transactions were experienced investors who
proceeded with their plans to create an artificial tax loss for the benefit of
Williams or other Bricolage clients, despite clear warning against “Partnership
Straddle Tax Shelter[s]” by IRS Notice 2002-50, 2002-28 I.R.B. 98.44 The
plaintiffs were negligent for failing “to make a reasonable attempt to comply
with the provisions of this title[,]” 26 U.S.C. § 6662(c), which the Treasury
Regulations define to include “revenue rulings or notices . . . issued by the
Internal Revenue Service and published in the Internal Revenue Bulletin[,]” 26
C.F.R. § 1.6662-3(b)(2). After the notice issued, the partnerships were negligent
in proceeding with the FOCus program, including filing partnership tax returns
reflecting the FOCus transactions. The Notice specifically warned that penalties
could result from what the partnerships planned and executed, viz.,
“prearrange[d] . . . use of a straddle, a tiered partnership, a transitory partner”
to obtain a “permanent non-economic loss” from transactions lacking in
“economic substance.” Id. Consequently, the district court did not err in finding
that the partnerships failed to prove that they acted with due care and with
proper regard for the rules and regulations, and that they therefore exposed
themselves to the 20% negligence penalty.45 Because the partnerships claim
44
The partnerships were also on notice that similar partnership arrangements, Son of
BOSS transactions, were considered to be abusive tax shelters by the IRS. See I.R.S. Notice
2000-44 (“Tax Avoidance using Artificially High Basis,” published September 2000).
45
A notice is akin to a “revenue ruling” and is an interpretation of the law offered by
the IRS. While not binding precedent, revenue rulings—and notices—are entitled to “special”
or “respectful consideration” and are “to be given weight as expressing the studied view of the
agency whose duty it is to carry out the statute.” Foil v. Comm’r, 920 F.2d 1196, 1201 (5th Cir.
1990); see also 26 C.F.R. § 601.201(a)(6) (defining revenue rulings); cf. 26 C.F.R. § 1.6662-
3(c)(1) (setting out procedures for bringing “good faith challenge[s] to the validity of” IRS
notices and regulations contrary to the taxpayer’s position).
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that they are entitled to the reasonable cause and good faith defense, however,
we now turn to that subject.
B. The Reasonable Cause and Good Faith Defense
Section 6664(c)(1) provides a narrow defense to § 6662 penalties if the
taxpayer proves it had (1) reasonable cause for the underpayment and (2) acted
in good faith.
First, the partnerships contend that in, making the 2001 FOCus
transactions, they were entitled to reasonably rely on what they claim to be
relevant authority, viz., Compaq Computer Corp. & Subsidiaries v.
Commissioner, 277 F.3d 778, 786 (5th Cir. 2001), UPS of America, Inc. v.
Commissioner, 254 F.3d 1014, 1018 (5th Cir. 2001), and IES Industries, Inc. v.
United States, 253 F.3d 350, 354 (8th Cir. 2001). We disagree. These cases are
not apposite here. In each of them, the court concluded that the transaction
challenged by the IRS had economic substance because it involved a reasonable
possibility of significant profit or loss. See Compaq, 277 F.3d at 786 (“Compaq’s
U.S. tax on that net pre-tax profit was roughly $644,000. Subtracting $644,000
from the $1.894 million results in an after-tax profit of about $1.25 million. The
transaction had economic substance.”); IES, 253 F.3d at 354 (“The foreign
corporation’s withholding and payment of the tax on IES’s behalf is no different
from an employer withholding and paying to the government income taxes for
an employee: the full amount before taxes are paid is considered income to the
employee. Because the entire amount of the ADR dividends was income to IES,
the ADR transactions resulted in a profit, an economic benefit to IES.” (citation
omitted)). In UPS, perhaps the most dissimilar case, because it involved an
ongoing legitimate business rather than a tax shelter, the court held that the
taxpayer’s restructuring of its excess-value program as insurance provided by
an overseas affiliate had real economic substance in addition to tax benefits, and
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so was not a sham transaction. 254 F.3d at 1018 (“The kind of ‘economic effects’
required to entitle a transaction to respect in taxation include the creation of
genuine obligations enforceable by an unrelated party. . . . The restructuring of
UPS’s excess-value business generated just such obligations. There was a real
insurance policy between UPS and National Union that gave National Union the
right to receive the excess-value charges that UPS collected. And even if the
odds of losing money on the policy were slim, National Union had assumed
liability for the losses of UPS’s excess-value shippers, again a genuine obligation.
. . . Nor did the reinsurance treaty with OPL, while certainly reducing the odds
of loss, completely foreclose the risk of loss because reinsurance treaties, like all
agreements, are susceptible to default.”). In the present case, dissimilar to the
situations in Compaq, IES, and UPS, the district court found after a lengthy
bench trial that the 2001 FOCus transactions by the partnerships were part of
a sham tax shelter and lacked economic substance because none of the
challenged transactions presented a reasonable possibility of significant profit
or loss, or created reciprocal obligations with an unrelated party that affected
the partnerships’ economic interest, and we have affirmed those findings as
being reasonable and not clearly erroneous.
Next, the partnerships argue that their negligence should have been
excused because Williams, who ultimately became their “controlling member,”
acted for them in relying on the advice of professionals. While it is true that
actual reliance on the tax advice of an independent, competent professional may
negate a finding of negligence, see, e.g., United States v. Boyle, 469 U.S. 241, 250
(1985), the reliance itself must be objectively reasonable in that the taxpayer
supplied the professional with all the necessary information to assess the tax
matter and that the professional himself does not suffer from a conflict of
interest or lack of expertise that the taxpayer knew of or should have known
about, see 26 C.F.R. § 1.6664-4(c); Ellwest Stereo Theatres, Inc. v. Comm’r, 70
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T.C.M. (C.C.H.) 1655 (T.C. 1995); see also Zfass v. Comm’r, 118 F.3d 184, 189
(4th Cir. 1997).
Thus, a taxpayer’s reliance on the advice of a professional may constitute
reasonable cause and good faith where the taxpayer proves by a preponderance
of the evidence that: (1) the taxpayer reasonably believed that the professional
upon whom the reliance was placed was an independent, competent adviser,
without a conflict of interest, and with sufficient expertise to justify reliance; (2)
the taxpayer provided all necessary and accurate information to the adviser; and
(3) the taxpayer actually relied in good faith on the adviser’s judgment. See SAS
Inv. P’s v. Comm’r, 103 T.C.M. (CCH) 1845 (T.C. 2012) (citing Neonatology
Assocs., P.A. v. Comm’r, 115 T.C. 43, 98-99 (T.C. 2000), aff’d, 299 F.3d 221 (3d
Cir. 2002); 26 C.F.R. § 1.6664-4(c)(1)).
The partnerships’ argument that they are entitled to complete exculpation
of negligence and disregard of tax laws and regulations because of Williams’
reliance on the tax advice of Arnold & Porter, KPMG, and Williams’ own
attorneys at Baker Donelson, is a non-starter, however. The partnerships admit
that Williams did not become a “controlling member” of Nevada until December
4, 2001 and of Carson until December 12, 2001. The record supports the findings
by the IRS and the district court that the partnerships’ FOCus-related
negligence and disregard of tax laws, rules and regulations commenced prior to
those dates. Before Williams became involved, the partnerships had already
prearranged the unlawful FOCus tax avoidance scheme and had effectuated the
Reno straddle trades lacking economic substance. Williams’ subsequent reliance
on tax law advice by counsel cannot serve retroactively to shield the
partnerships from liability for their prior negligence and disregard of rules and
regulations in formulating, promoting, and beginning to carry out the unlawful
FOCus tax avoidance scheme.
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Moreover, assuming without deciding that Williams, as “controlling
member,” acted within the scope of his authority to act for the partnerships in
obtaining and relying on the tax opinions pertaining to the FOCus program from
Arnold & Porter,46 and assuming that Arnold & Porter was not only a competent
adviser, but was also independent and conflict-free,47 we conclude that the
partnerships could not reasonably rely on Arnold & Porter’s tax opinions in good
faith because Williams and the partnerships failed to prove by a preponderance
of the evidence that they supplied the professional with all pertinent information
necessary to assess the purpose and elements of the transactions at issue as they
were actually effectuated.
The advice upon which the taxpayer claims reliance “must be based upon
all pertinent facts and circumstances and the law as it relates to those facts and
circumstances.” 26 C.F.R. § 1.6664-4(c)(1)(i); see also id. § 1.6664-4(c)(ii)
(providing that professional advice must not be based upon a representation or
46
The government argues that Williams could not act for the partnerships because
Bricolage, not Williams, was the managing “administrative member.” Williams argues that,
as the partnerships’ “controlling member,” he could so act. The district court did not
specifically address this issue, and we need not settle this dispute for the first time on appeal
because, even assuming for the purposes of argument that Williams did act on behalf of the
partnerships, the defense that the partnerships urge lacks merit.
47
The evidence in the record suggests, but does not conclusively demonstrate, that
Arnold & Porter suffered from a conflict of interest due to its prior representation of the
Bricolage partnerships and the law firm’s commitment to render a “more likely than not”
opinion approving the FOCus program even before it was described and offered to Williams
in the KPMG PowerPoint on October 2, 2001. Cf. Stobie Creek Investments LLC v. United
States, 608 F.3d 1355, 1382-83 (Fed. Cir. 2010) (affirming the district court’s finding that a
taxpayer was “objectively unreasonable” to rely on a the tax advice of two law firms because
one firm was a “promoter” of the tax shelter at issue and the other law firm “was an agent of
the promoter,” thus putting a reasonable taxpayer on notice that the firms were not in a
position to provide objective or financially disinterested advice); Zfass, 118 F.3d at 189(affirming the rejection of taxpayer’s defense that he relied on the advice of his accountant
before proceeding with a tax shelter because, among other reasons, the taxpayer did not call
the accountant as a witness and did not adduce evidence “to show what knowledge or
information [the accountant] had regarding the investment . . . [or to] establish[ ] that [the
accountant] was aware of the non-tax aspects of the plan”).
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assumption which the taxpayer knows, or has reason to know, is false or
unlikely to be true). As the Arnold & Porter tax opinions clearly reflect,
however, the facts and circumstances that deprived the pertinent transactions
and the resulting tax loss of economic substance were not provided to the law
firm by the partnerships. Specifically, the tax opinions do not set forth as a basis
for analysis the precisely offsetting straddles that by design could not yield a
profit, the embedding of the loss legs in Reno, the reallocation of the Reno gain
legs to the transitory owners of Carson, the tightly collared Yen trade that could
yield only a negligible profit or loss, or the unnecessary and gratuitous personal
loan guarantee by Williams solely to increase his tax basis in Carson. Thus, the
tax opinion letters did not analyze all of the pertinent facts and circumstances
of the FOCus transactions and arrangements that the partnerships actually
engaged in with the participation of Williams, Bricolage, and their transitory
partners. In addition, the tax opinions were explicitly based on Williams’ and
the partnerships’ misrepresentations that transactions were engaged in only for
business purposes as “a practical and cost effective means for [Williams] to
pursue [his] investment strategy.” Thus, the letters omitted the key factor that
the transactions between November and December 2001 had no purpose other
than to create an $18 million tax loss deduction for Williams. In sum, the Arnold
& Porter tax opinions were not based on all of the pertinent facts and
circumstances necessary to analyze the purpose and elements of the FOCus
transactions that the partnerships actually planned and carried out. Williams
and the partnerships knew or had reason to know that the true purpose and the
characteristics of the tax-motivated transactions were not set forth and
discussed in the tax opinion letters, and that the tax opinions therefore could not
be relied upon in good faith because they were not based on all of the relevant
facts and circumstances.
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The partnerships contend that, independently of Arnold & Porter, they
relied on the advice of Williams’ counsel at Baker Donelson. However, the
evidence supports the district court’s finding that the attorneys at Baker
Donelson relied on the Arnold & Porter opinions in rendering their advice,
Nevada Partners, 714 F. Supp. 2d at 633, and, because the partnerships and
Williams were aware of this, they could not reasonably rely on the advice of
Baker Donelson independently of Arnold& Porter. The district court concluded
that Williams and the partnerships were “superbly educated, experienced and
sophisticated investors,” and that they did not reasonably rely in good faith on
this advice under the circumstances. Id. at 640. Consequently, the district court
did not clearly err in finding that the partnerships failed to carry their burden
of proving the defense of reasonable reliance in good faith so as to excuse them
for their negligence and disregard of tax laws, rules and regulations.
CONCLUSION
For the foregoing reasons, we AFFIRM the district court’s determinations
that: (1) the FOCus transactions lacked economic substance and must be
disregarded for tax purposes; (2) the negligence penalty is applicable and the
partnerships are not entitled to the reasonable cause defense; and (3) the
valuation misstatement penalty is inapplicable. As to the remaining actions
addressing the FPAAs premised on the government’s alternative theory under
Treasury Regulation § 1.701-2, and as to the district court’s approval of the
alternative substantial understatement penalty, we VACATE and RENDER
judgment for the plaintiffs.
39